State and Local Tax Refunds & the Tax Benefit Rule

In years prior to 2019, and the enactment of the Tax Cuts and Jobs Act (TCJA), taxpayers were accorded an “unlimited” federal income tax deduction for all state and local income taxes as well as real estate taxes, if they were able to itemize deductions. In those instances when the state and local income taxes were found to be overpaid, and the overpayment was refunded in the succeeding year, the refund was required to be reported as taxable income in that year. The tax concept behind this treatment is codified in Internal Revenue Code §111(a), which states:

Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter.

This provision is often referred to as the “tax benefit rule,” and it is what has served to limit inclusion of the state income tax deduction in the past due to various circumstances, including when the alternative minimum tax (AMT) applied to a taxpayer.

A highly controversial provision of the TCJA capped the state and local income taxes (SALT) that an individual can deduct when itemizing their deductions. (see related posts below)

Per the new rules, the deduction for taxes paid or accrued by an individual during the tax year that are not directly connected with a trade or business, or with property held for the production of income, is limited for tax years beginning after December 31, 2017, and before January 1, 2026. Specifically, for tax years 2018 through 2025, an individual may claim an itemized deduction on Schedule A of up to only $10,000 ($5,000 for married taxpayer filing a separate return) for: (1) state and local real property taxes; (2) state and local personal property taxes; and (3) state and local income taxes, as well as state and local sales taxes deducted in lieu of state and local income taxes.

Recently, a number of questions have arisen regarding the potential taxability of a state income tax refund for taxpayers where the taxpayers in question had their state tax deductions limited by the $10,000 limit on such deductions under the new rule. The primary question is whether a portion of the refund equal to the refund amounts times the ratio of income taxes to total state and local taxes subject to the $10,000 limit will be considered taxable income in calendar 2019.

While no official guidance has been released to this point, at least some sources at the Internal Revenue Service have indicated that this prorated refund calculation is what should be reported in 2019.

The tax benefit rules look at whether, had the amount that was later recovered not been claimed on the original return, there would be either a change in tax for that year or a change in a carryover (net operating loss, capital loss, etc.) that could affect tax in a different year. If the removal of the deduction would not have impacted either the tax for the year of deduction or any of the carryovers, the recovery is not taxable.

The following examples provide an illustration of the mechanics of the tax benefit rule and how it should work with respect to the new law and the $10,000 annual limitation.

Example 1

Joe and Denise Smith itemize deductions on their 2018 income tax return. On Schedule A they listed real estate taxes of $7,000 and state income taxes of $7,000. When their 2018 state income tax return was prepared, the couple received a state tax refund of $2,000.

The Smith’s total taxes subject to the $10,000 limit was $14,000, resulting in an allowed deduction of $10,000 and a similar reduction in their taxable income. If $2,000 of their state income taxes were to be disallowed by the IRS, their total taxes before the limit would drop to $12,000. However, their deduction would remain at $10,000 and their taxable income and tax would remain unchanged. The change would also have no effect on any net operating loss or capital loss on the Smith’s return for 2018. As such, the amount of their state income tax refund provided no income tax benefit in 2018.

Thus, the $2,000 refund is excluded from their 2019 income due to the operation of IRC §111.

An alternative fact pattern illustrates how a portion of the state income tax refund might be taxable.

Example 2

Assume the same facts except their state tax refund was $5,000. In this case only $4,000 of the refund represents amount that would not serve to increase their tax should it be disallowed on exam. If the full $5,000 refund were disallowed, their limited tax deduction under the TCJA would drop to $9,000 from $10,000, resulting in an increase in taxable income and an increase in tax that can be traced to $1,000 of the refund.

IRC §111 would still serve to exclude $4,000 of the refund from their 2019 income. But $1,000 of the refund would be reported as income on their 2019 income tax return, as that amount is not protected by this tax benefit rule.

The implications of the Tax Cuts and Jobs Act are extensive, and many elements of the reach of that law are being discovered in the process of preparing income tax returns for 2018 and planning for 2019. Please contact Bob Grossman or Don Johnston at 412-338-9300 with questions or to discuss your situation.